Increase in synthetic PB and alternative financing as primes face squeeze
Basel III capital and leverage ratios are likely to facilitate a substantial increase in synthetic prime brokerage financing and alternative sources of hedge fund financing.
Papers published by research consultancy TABB Group as well as both Citi and J.P. Morgan, in 2014 highlighted attempts by prime brokers to reduce their dependency on short-term funding, hedge fund investor restrictions on re-hypothecation of collateral and Basel III capital requirements are all going to lead to an increase in the cost of financing. This is forcing a number of prime brokers to scale back on their hedge fund relationships with some firms culling their less profitable or smaller hedge fund managers.
“Alternative sources of hedge fund financing are emerging. The most common is the emergence of synthetic prime brokerage whereby managers have access to derivative based equity financing through total return swaps and contracts for difference. We have heard about private equity firms sitting on substantial amounts of dry power consider setting up financing operations but this has yet to enter the fray,” said Radi Khasawneh, research analyst at TABB Group in London and author of “Equity Prime Brokerage: Exploring Unchartered Territory.”
Private equity firms could be one primary contender for this as many are sitting on a lot of unspent capital. Preqin, the London-based data provider, said private equity firms were sitting on approximately $1.07 trillion of dry powder at the end of 2013, an increase of $130 billion from 2012.
The rising financing costs have resulted in a swing from the multi prime brokerage model that proliferated in the aftermath of the Lehman Brothers failure. The TABB Group research highlights that hedge funds and long-only managers are using fewer prime brokers since the financial crisis, and added this trend was likely to continue.
A study by Barclays Prime Finance said the tightening on financing would disproportionately impact illiquid or highly leveraged strategies. The study said the average hedge fund’s returns could decline by 10 to 20 basis points with fixed income arbitrage – one of the most leveraged strategies at 13 times its Net Asset Value (NAV) – being hurt the most, with returns diminishing by anywhere between 40 and 80 basis points.
A growing number of hedge funds are rejigging their businesses by expanding their treasury function, particularly those running large, leveraged multi-strategy funds. “This is a theme that we are seeing. Some hedge funds are improving their alpha by enhancing their treasury functions,” said Khasawneh.
Some hedge funds have been raising permanent capital via closed-end funds or by establishing reinsurance vehicles. Reinsurance vehicles, often domiciled in Bermuda, enable managers to build up a fixed capital base not subject to redemptions and which are exempt from US taxation as long as the reinsurance vehicle is not conducting business in the US. A handful of managers including Paulson & Co have established such ventures.
The challenges around financing coincide with regulatory clampdowns on re-hypothecation. There is a strong possibility the European Commission (EC) could clamp down on re-hypothecation practices at prime brokers. Some expect the EC to emulate the Securities and Exchange Commission’s (SEC) Rule 15c3-3 which prohibits prime brokers from re-hypothecating more than 140% of a client’s debit balance, although the EC could impose a lower threshold.
The EC has already proposed Securities Financing Transaction regulation, which requires alternative investment fund managers (AIFMs) and UCITS managers to give consent to assets being re-hypothecated. The collateral giver must be supplied in writing details of the risks re-hypothecation entails by the collateral taker and this must be confirmed by written agreement; and the financial instruments received as collateral must be transferred to an account in the name of the receiving counterparty.